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China Bites The Cherry

August 12, 2015 8:56 amAugust 12, 2015 8:56 am

Are you staring to have the feeling that when it comes to economic policy Xi-who-must-be-obeyed has no idea what he’s doing?

China’s decision to devalue the renminbi had some economic logic behind it. As David Beckworth rightly points out, it’s not just about gaining a competitive advantage. China clearly has a weakening economy, whatever the official numbers may say, and would like to use monetary stimulus. But monetary autonomy and a fixed exchange rate don’t go well together; China’s capital controls give it some leeway, but it is nonetheless suffering from a lot of capital flight — and it wants to liberalize the capital account in pursuit of reserve-currency status. (A foolish goal, but that’s a subject for another day.)

So it would make sense on purely economic grounds for China to move to a free float, and gain the freedom to use monetary policy that, say, Japan has.

But it’s important to understand how that works. When Japan loosens money, it creates an incentive to move funds abroad, causing the yen to fall. This process only stops once the yen has fallen enough that investors consider it undervalued, and are willing to buy Japanese securities in the expectation of a future yen rise. Exchange rate overshooting is an essential part of the story.

China, however, did not let the renminbi float, nor did it devalue by enough to persuade investors that any future move was likely to be up. Instead, it only devalued a little.

This is what Charlie Kindleberger used to call “taking the first bite of the cherry”. (Nobody takes just one bite out of a cherry.) China has now demonstrated that its currency peg is no longer solid; but it has come nowhere near to devaluing enough to create expectations of future appreciation. This is a recipe for convincing investors that the future direction of the currency is down — which means that capital flight will accelerate (and apparently already has.)

Now what? China could just let the renminbi float; given the current state of the Chinese economy, that would surely mean a large depreciation. But this would greatly increase trade tensions and pose problems for foreign policy. Maybe that’s a tradeoff worth accepting, but nothing in events so far suggests that China’s leadership was prepared to take that step. Instead, they went for a small move that was sufficient to destabilize expectations while producing trivial benefits.

A reminder, then, of the lack of wisdom with which the world is governed.